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Book Review: Panic, Prosperity, and Progress

Friday, July 25th, 2014

PPP I love economic history books, and I believe that most investors should read economic history.  History offers a broader paradigm for analyzing investment situations than mathematical models do.

Mark Twain is overquoted on this, but only because he deserves to be quoted:
“History doesn’t repeat itself, but it does rhyme.”

You can get a lot of insights into the present by reading this book.  So many disasters occurred because people presumed that the future would be much like the past, and they ended up being the ones that took the large losses.

Further, this book will point out that how an asset is held will make a difference in its future performance.  When there is not a lot of debt behind an asset, there may be good prospects.  But when there is a lot of debt behind an asset, prospects are not so good because those that own the asset are relying on the asset to perform.  Those who own an asset free and clear may get hurt if the price falls, but they won’t be ruined like the guy who has borrowed to own it.

This book takes on every major systemic crisis from the Tulip Bubble to the recent Housing/Banking crisis.  This is my bread & butter, but I learned things in many of the chapters regarding things I thought I knew well.  Truly, a great book.

What Could Have Made the Book Better

Financial crises don’t appear out of nowhere.  Leaving aside war on your home soil, plague, famine, communism, etc., there is usually a boom that gives way to a bust.  In some of his chapters, he could have spent more time describing the boom that led to the bust.  This is important, because readers need to learn intuitively that the boom-bust cycle is normal. NORMAL!

Ignore the economists who think they can control the economy.  They can’t do it, and this book helps to say that.  Economists are always behind the curve.  Politicians are even further behind the curve.  Regulators are still further behind the curve, and usually do the wrong thing during crises as a result.

The author could have done more to suggest how individuals and policymakers should respond to financial crises.  Better to have a book that advises us, than one that just reports.

Quibbles

On pages 421-422, he shows that he doesn’t get securitization, and blames the rating agencies, who were forced to rate novel debt for which they did not have a good model because the regulators outsourced credit risk measurement to them.

Summary

Most people would benefit from this book.  It will teach you about financial crises and their aftermath.  If you want to, you can buy it here: Panic, Prosperity, and Progress: Five Centuries of History and the Markets (Wiley Trading) (Hardback) – Common.

Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

 

On Current Credit Conditions

Friday, July 18th, 2014

This should be short.  Remember that credit and equity volatility are strongly related.

I am dubious about conditions in the bank loan market because Collateralized Loan Obligations [CLOs] are hot now and there are many that want to take the highest level of risk there.  I realize that I am usually early on credit issues, but there are many piling into CLOs, and willing to take the first loss in exchange for a high yield.  Intermediate-term, this is not a good sign.

Note that corporations take 0n more debt when rates are low.  They overestimate how much debt they can service, because if rates rise, they are not prepared for the effect on earnings per share, should the cost of the debt reprice.

It’s a different issue, but consider China with all of the bad loans its banks have made.  They are facing another significant default, and the Chinese Government looks like it will let the default happen.  That will not likely be true if the solvency of one of their banks is threatened, so keep aware as the risks unfold.

Finally, look at the peace and calm of low implied volatilities of the equity markets.  It feels like 2006, when parties were willing to sell volatility with abandon because the central banks of our world had everything under control.  Ah, remember that?  Maybe it is time to buy volatility when it is cheap.  Now here is my question to readers: aside from buying long Treasury bonds, what investments can you think of that benefit from rising implied volatility and credit spreads, aside from options and derivatives?  Leave you answers in the comments or email me.

This will sound weird, but I am not as much worried about government bond rates rising, as I am with credit spreads rising.  Again, remember, I am likely early here, so don’t go nuts applying my logic.

PS — weakly related, also consider the pervasiveness of BlackRock’s risk control model.  Dominant risk control models may not truly control risk, because who will they sell to?  Just another imbalance of which to be wary.

One More Note on Failure

Saturday, July 12th, 2014

Recently, we had a problem at the Merkel house: a toilet overflowed and the water did not shut off, flooding the room, and leaked into the basement.  Why did this happen?  Two things went wrong at the same time:

  1. The toilet needed to be plunged, because there was a blockage preventing water discharge, and
  2. The flapper malfunctioned, and so water continued to flow.

If only one of these problems had happened, we would have had an ordinary problem.  I can plunge a toilet, easy.  I can hear the toilet singing, and know that the flapper is up, jiggle the handle, and end the problem.

Most of the time, when we plan against failure, we look at solutions that address single failures.  We do not contemplate two things going wrong at once.

Yet, when we look at big failures in investment, there are often two things that went wrong at the same time.  Usually it follows a pattern like this:

  1. Take a risk that in ordinary times often works out, but
  2. You don’t get that times are not ordinary, and so the odds are actually stacked against you.

I have several examples for this.  Taking on debt to buy a house was a wonderful strategy until overall debt levels to finance housing got to high, but at that time, the momentum effect of rising house prices was sucking people into buying houses, because they thought it was easy money.

Financial stocks were the market leaders for many years up through 2007, as investors assumed that ordinary risk control would protect the banking system.  But what happens when debt levels are too high, so that many debts are incapable of being paid?

As Warren Buffett has said (something like), “We get paid to think about the things that can’t happen.”  Multiple failures leading to large bad results are worth thinking about.  So what aren’t we thinking about now?

  • Failures in retirement security systems as the Baby Boomers age.
  • Failures in government debt as overleveraged governments can’t make debt payments.
  • Inflation rises rapidly as the economy revives amid increased lending from banks.
  • Deflation persists as the central bank tries to force-feed credit to an already overleveraged economy.

(There are many patting themselves on the back thinking that the Central Banks and Governments got us out of a crisis, when they only delayed the crisis.  High nominal debt levels relative to GDP create their own crisis.)

I would encourage you to think about your investments, and ask the following questions:

  • Are there hidden factors that could lead to a big failure?  (Think of what happened to mortgage REITs in 2008 when the repo market crashed.)
  • How well would the investment fare if inflation went up significantly?
  • How well would the investment fare if real interest rates went up significantly?
  • How well would the investment fare if we hit another patch where financing is not available?  Can the investment self-fund?
  • How much future prosperity does the current price of the investment embed in its valuation?

I know, glum words.  But this might be a good time to look at what you own, and ask how survivable it is under stressed conditions.

All for now.

Inflation?

Friday, June 27th, 2014

Is price inflation growing?  I see three data points, amid slow nominal growth:

  • Japan
  • US
  • Crude Oil prices have been rising, amid the relaxation of exports in the US, and weak global demand.

This is early, but I have adjusted my bond portfolio to reflect this last month, buying some TIPS.

This is not worthy of full action, but it is interesting to see the three above rising at the same time.  That’s all.

A Few Notes on Bonds

Wednesday, June 25th, 2014

My comments this evening stem from a Bloomberg.com article entitled Bond Market Has $900 Billion Mom-and-Pop Problem When Rates Rise.  A few excerpts with my comments:

It’s never been easier for individuals to enter some of the most esoteric debt markets. Wall Street’s biggest firms are worried that it’ll be just as simple for them to leave.

Investors have piled more than $900 billion into taxable bond funds since the 2008 financial crisis, buying stock-like shares of mutual and exchange-traded funds to gain access to infrequently-traded markets. This flood of cash has helped cause prices to surge and yields to plunge.

Once bonds are issued, they are issued.  What changes is the perception of market players as they evaluate where they will get the best returns relative expected future yields, defaults, etc.

Regarding ETFs, yes, ETFs grow in bull markets because it pays to create new units.  They will shrink in bear markets, because it will pay to dissolve units.  That said when ETF units are dissolved, the bonds formerly in the ETF don’t disappear — someone else holds them.

But in a crisis, there is no desire to exchange existing cash for new bonds that have not been issued yet.  Issuance plummets as yields rise and prices fall for risky debt.  The opposite often happens with the safest debt.  New money seeks safety amid the panic.

Last week, Fed Chair Janet Yellen said she didn’t see more than a moderate level of risk to financial stability from leverage or the ballooning volumes of debt. Even though it may be concerning that Bank of America Merrill Lynch index data shows yields on junk bonds have plunged to 5.6 percent, the lowest ever and 3.4 percentage points below the decade-long average, the outlook for defaults does look pretty good.

Moody’s Investors Service predicts the global speculative-grade default rate will decline to 2.1 percent at year-end from 2.3 percent in May. Both are less than half the rate’s historical average of 4.7 percent.

Janet Yellen would not know financial risk even if Satan himself showed up on her doorstep offering to sell private subprime asset-backed securities for a yield of Treasuries plus 2%.  I exaggerate, but yields on high-yield bonds are at an all-time low:

Could spreads grind tighter?  Maybe, we are at 3.35% now.  The record on the BofA ML HY Master II is 2.41% back in mid-2007, when interest rates were much higher, and the credit frenzy was astounding.

But when overall rates are higher, investors are willing to take spread lower.  There is an intrinsic unwillingness for both rates and spreads to be at their lowest at the same time.  That has not happened historically, though admittedly, the data is sparse.  Spread data began in the ’90s, and yield data in a detailed way in the ’80s.  The Moody’s investment grade series go further back, but those are very special series of long bonds, and may not represent reality for modern markets.

Also, with default rates, it is not wise to think of them in terms of averages.  Defaults are either cascading or absent, the rating agencies, most economists and analysts do not call the turning points well.  The transition from “no risk at all” in mid-2007 to mega-risk 15 months later was very quick.  A few bears called it, but few bears called it shifting their view in 2007 – most had been calling it for a few years.

The tough thing is knowing when too much debt has built up versus ability to service it, and have all short-term ways to issue yet a little more debt been exhausted?  Consider the warning signs ignored from mid-2007 to the failure of Lehman Brothers:

  • Shanghai market takes a whack (okay, early 2007)
  • [Structured Investment Vehicles] SIVs fall apart.
  • Quant hedge funds have a mini meltdown
  • Subprime MBS begins its meltdown
  • Bear Stearns is bought out by JP Morgan under stress
  • Auction-rate preferred securities market fails.
  • And there was more, but it eludes me now…

Do we have the same amount of tomfoolery in the credit markets today?  That’s a hard question to answer.  Outstanding derivatives usage is high, but I haven’t seen egregious behavior.  The Fed is the leader in tomfoolery, engaging in QE, and creating lots of bank reserves, no telling what they will do if the economy finally heats up and banks want to lend to private parties with abandon.

That concern is also revealed in BlackRock Inc.’s pitch in a paper published last month that regulators should consider redemption restrictions for some bond mutual funds, including extra fees for large redeemers.

A year ago, bond funds suffered record withdrawals amid hysteria about a sudden increase in benchmark yields. A 0.8 percentage point rise in the 10-year Treasury yield in May and June last year spurred a sell-off that caused $248 billion of market value losses on the Bank of America Merrill Lynch U.S. Corporate and High Yield Index.

Of course, yields on 10-year Treasuries (USGG10YR) have since fallen to 2.6 percent from 3 percent at the end of December and company bonds have resumed their rally. Analysts are worrying about what happens when the gift of easy money goes away for good.

With demand for credit still weak, it is more likely that rates go lower for now.  That makes a statement for the next few months, not the next year.  The ending of QE and future rising fed funds rate is already reflected in current yields.  Bloomberg.com must be breaking in new writers, because the end of Fed easing is already expected by the market as a whole.  Deviations from that will affect the market.  But if the economy remains weak, and lending to businesses stays punk, then rates can go lower for some time, until private lending starts in earnest.

Summary

  • Is too much credit risk being taken?  Probably.  Spreads are low, and yields are record low.
  • Is a credit crisis near?  Wait a year, then ask again.
  • Typically, most people are surprised when credit turns negative, so if you have questions, be cautious.
  • Does the end of QE mean higher long rates?  Not necessarily, but watch bank lending and inflation.  More of either of those could drive rates higher.

Q&A with The Forbidden Game Author Dan Washburn

Sunday, June 22nd, 2014

For anyone interested in learning more about Dan Washburn, author of The Forbidden Game,  you can consult his blog here.  Aside from that, you can read my Q&A with him here.  Hey, thanks for reading — I’m not a golfer, though I did it as a child, and was a caddy for some years.  It is a phenomenon is society, and should be understood.

Anyway, here is the Q&A.  In general, I say to authors that they don’t have to take all of my questions, and thus, you will see gaps in the numbers.  Here it goes:

1.       From the book Prisoner of the State, Zhao Ziyang, even while in captivity was allowed to go golfing.  Now, many in the Party distrusted Zhao because he had adopted too many Western habits and modes of thought.  Has golf been legitimized for Party members to partake in, so long as they aren’t too flamboyant about it? 

I don’t think so. Golf remains a taboo topic for China’s political elite, perhaps even more so now than in years past thanks to Xi Jinping’s ongoing crackdown on government corruption. Simply put, Chinese officials shouldn’t be able to afford to play golf in China. Their salaries are modest (last year, it was reported that President Xi’s annual salary is just $19,000) and golf in China is extremely expensive (it can cost $150, often more, to play 18 holes). So, while most Chinese assume that all government officials have other sources of income, playing golf on a regular basis would be a rather conspicuous admission of double-dealing. We all know some Chinese officials are filthy rich, and some indeed do play golf — but they still need to do so on the sly.

 

4.       In the US, golf is usually thought of as a rich man’s game.  Your book seems to indicate that it is also true in China, but is it more so, or less so than in the US?

Golf on average is much more expensive in China than in the United States. There are no public courses, per se, so you’re stuck having the pay a hefty fee to get on a so-called “private” course. Those on a budget usually stick to the driving ranges, which are often quite crowded.

 

5.       You got me to root for each of your main characters, Zhou Xunshu, Wang Libo, and Martin Moore.  It’s a much more interesting book as a result, than say a straight golf history of China book.  How did you settle on this structure of the book?  How many other characters did you try out before settling on these three?

That’s great to hear, David. I always envisioned this as a character-driven book, narrative non-fiction that keeps you turning pages like a novel. Originally, the book was going to focus solely on Zhou, with other stories related to golf’s development in China branching off from his underdog narrative. But eventually my editor and I decided, I think wisely, to add two more characters that readers could become invested in. The first people who came to mind were Martin and Wang. They were good people with very interesting stories to tell, and they allowed us to explore aspects of golf’s rise in China that Zhou on his own did not.

 

6.       Why did the Chus, running Mission Hills in China insist that they had to build the largest golf course complex in the world, not just once but twice?  Were they that way in all of their business dealings?

I’m not quite sure where the drive to be the biggest and best at everything stemmed from, but the Chus certainly weren’t alone. I recall at one point during my time in China that Shanghai had plans to be home to the world’s fastest train, the world’s tallest building, even the world’s largest ferris wheel. As China has emerged in recent decades, it has become a nation of superlatives. Mission Hills fits right in.

 

8.       As you wrote the book, what thing or things surprised you the most?

When I started covering golf tournaments in China in 2005, I knew little about the issues surrounding the development of the game there. But the more I dug, the more I realized that golf, and the complex world that surrounds it, is really a microcosm of China at the moment. The story touches on everything: the booming economy, the widening gap between rich and poor, rural land rights, environmental concerns, wild west development, and political intrigue. Golf, surprisingly, seemed to be perfect lens through which to view China during the first decade of this new millennium.

 

9.       Why did the book’s title change from Par for China, to The Forbidden Game?

It was a natural evolution. Par for China was always my working title, but the publisher really fell in love with The Forbidden Game, which was the title of a related story I wrote for Slate a few years ago. And it works on many levels. Golf was, in fact, forbidden in China for some 35 years after the Communists came to power (2014 marks the 30-year anniversary of the opening of modern China’s first golf course). Playing golf was also forbidden for Zhou when he worked as a golf course security guard. And today, building new golf courses is supposedly forbidden in China — and we all know how well that’s working.

 

10.   How long were you at work on the book?  6-8 years?

Yes, it’s been a labor of love. I first met Zhou late in the summer of 2006, and I found his story so fascinating I immediately started formulating a book in my mind. Of course, it took me another four years to actually sell the book, and a few more after that to write it. Those extra years allowed be to add a lot more depth to the story, though, so it all worked out in the end.

 

11.   How avid of a golfer are you?

I’m not. So, it’s a good thing this isn’t a how-to book. I took some lessons while in China, but quite honestly couldn’t afford to be an avid golfer there. Once I moved back to the U.S., all of my free time was spent writing. So, now that I have completed my golf book, now maybe I can finally take up golf!

Book Review: The Forbidden Game

Sunday, June 22nd, 2014

forbidden-game-9781851689484_0 I’m not a golfer, but I really liked this book.  The charm of the book is that it takes us through the lives of three men, and a host of lesser characters, and shows us how the growth of golf in China shaped their lives.  Two of the protagonists are Chinese, and one American.

The American, Martin Moore, was a promising golf course designer who did increasingly well designing courses in the US, Thailand, and China.   He learned how to get things done amid demanding bosses and ambiguous regulation.  Is building a golf course forbidden or not?  What if we call it a “health club?”  What if many locals object to their land being expropriated?

He succeeded amid many obstacles.  The next protagonist, and the one who had the most dramatic success was Zhou Xunshu, a man who went from not knowing anything about golf — an industrial worker, a common man, to being a golf professional.  His efforts were significant, and he underwent many hardships as he pursued his dream.

Then there is Wang Libo, a man who gets displaced by his home getting taken from him to build a golf course, and he takes the opportunity and builds a store/bar/restaurant near the complex to profit from the opportunity.

Three engaging characters amid the ambiguity of changing regulations, and whether it was legal to build new courses or not.

You will learn a lot about China in the process… what it is like dealing with an all-powerful Party whose machinations are secret.  And yet, one where if enough people protest, you can’t do anything, even if you have all of the permits in place.

You will get a behind-the scenes look at creating the world’s largest golf course twice, and the ambition of those who wanted to see it done quickly.

You will also experience the Chinese Dream, as the book’s subtitle suggests… the dreams and goals of those who want to live a life similar to middle-class Americans, but all the more poignant, because the path to getting there is often unclear.

To those reading me at Amazon.com, please Google “Aleph Blog Washburn” and you will be able to read a special Q&A with the author that I will post after writing this post.

This was an enjoyable book to read, and I think most people would learn something from it.

Quibbles

None.

Summary

This is a great book.  It will make a great gift to friends of yours who are golfers.  If you want to you can buy it here: The Forbidden Game: Golf and the Chinese Dream.

Full disclosure: The PR flack asked me if I would like a copy and I said yes.  She invited me to write a Q&A also.  Hey, look at the next post.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

To the Fed: A Picture is Worth 1000 Words

Thursday, June 19th, 2014

The FOMC statements are much longer than they used to be, and as such, are less clear, giving faulty signals to the markets.  If language is not likely to change much  for a while, why not drop the language  entirely, especially in cases where it affirms ideas that are obvious.

We may all know people in our lives who will say more and more if you don’t agree with them, because if you don’t agree with them, you don’t understand.  More words will bring clarity to you, and you will understand.  But what if they are nuts, and you are a sane person?  This is how I think about the FOMC — they are bad forecasters, and they don’t understand how weak monetary policy is in a period where there is too much debt.

So let’s try some pictures to replace the words of the FOMC:

central tendency_10374_image001

 

As I have said before, the FOMC is composed of overly optimistic neoclassical economists, who don’t know that their theories don’t work when and economy is too indebted.  They think: Real growth is our birthright, and price inflation promotes growth.  Neither are true.

central tendency_22274_image001

 

Note that they have been consistently pessimistic on the unemployment rate, flawed measure that it is.  Thus they think they need to keep monetary loose.

central tendency_26254_image001

 

Their views of PCE inflation reflect a view that monetary policy can easily achieve a 2% rate of inflation in the long run.  Pray tell, when have actions of the FOMC ever led to an equilibrium result?

Aside from that, the PCE index does not fairly represent inflation for the average person in the economy.  Maybe it reflects what the rich experience.

central tendency_29831_image001

 

This is a study in contrasts.  They were once more optimistic that Fed Funds rates would rise sooner, and that has not happened.  That said, they are now more certain that the Fed Funds rate will rise significantly in 2016.  As for the long run they are getting more pessimistic about economic growth, at least in their Fed Funds forecasts.

central tendency_1915_image001

This is another example of where the FOMC should take a step back, and not try to interpret every short-term wiggle.  As a group, they whipsawed in their view of when tightening would happen over the last three datapoints, when I would not have changed much.

To the Fed I say, “Say less, and provide more graphs.”  I understand that you don’t want to discredit yourselves because you are bad forecasters, but maybe you could get your points across in a more potent way by not diluting your message by many needless words.

 

 

Redacted Version of the June 2014 FOMC Statement

Wednesday, June 18th, 2014
April 2014June 2014Comments
Information received since the Federal Open Market Committee met in March indicates that growth in economic activity has picked up recently, after having slowed sharply during the winter in part because of adverse weather conditions.Information received since the Federal Open Market Committee met in April indicates that growth in economic activity has rebounded in recent months.The FOMC has constantly overestimated GDP growth, They forecast badly because they serve their political masters, who demand optimism to delude the public.
Labor market indicators were mixed but on balance showed further improvement. The unemployment rate, however, remains elevated.Labor market indicators generally showed further improvement. The unemployment rate, though lower, remains elevated.No significant change.  What improvement?
Household spending appears to be rising more quickly. Business fixed investment edged down, while the recovery in the housing sector remained slow.Household spending appears to be rising moderately and business fixed investment resumed its advance, while the recovery in the housing sector remained slow.Shades household spending down, raises their view on business fixed investment.

The FOMC needs to stop interpreting every short-term wiggle in the data.  They whipsawed on business fixed investment over the last three periods.

Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.No change.  Funny that they don’t call their tapering a “restraint.”
Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.No change.  TIPS are showing slightly higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.46%, up 0.05% from April.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate.No change.
The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced.The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced.No change.
The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.No change.  CPI is at 2.1% now, yoy.  Hey, above the threshold, and no comment from the FOMC?
The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.No change.
In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in May, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $20 billion per month rather than $25 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $25 billion per month rather than $30 billion per month.In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in July, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $15 billion per month rather than $20 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $20 billion per month rather than $25 billion per month.Reduces the purchase rate by $5 billion each on Treasuries and MBS.  No big deal.

 

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.No change
The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.No change.  But it has almost no impact on interest rates on the long end, which are rallying into a weakening global economy.
The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.No change. Useless paragraph.
If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.No change.  Says that purchases will likely continue to decline if the economy continues to improve.
However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.No change.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.No change.
In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.No change.  Monetary policy is like jazz; we make it up as we go.  Also note that progress can be expected progress – presumably that means looking at the change in forward expectations for inflation, etc.
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.No change.  Its standards for raising Fed funds are arbitrary.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.No change.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No change.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Richard W. Fisher; Narayana Kocherlakota; Sandra Pianalto; Charles I. Plosser; Jerome H. Powell; Jeremy C. Stein; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Richard W. Fisher; Narayana Kocherlakota; Loretta J. Mester; Charles I. Plosser; Jerome H. Powell; and Daniel K. Tarullo.Stanley Fischer is an interesting addition to the FOMC, because he would be capable of an independent opinion, not that he will ever do that.  Brainard and Mester are sock puppets.  If we see a dissent out of them, I will be shocked, and revise my opinion.

 

Comments

  • Small $10 B/month taper.  Equities and long bonds both rise.  Commodity prices rise.  The FOMC says that any future change to policy is contingent on almost everything.
  • They shaded household spending down, and raised their view on business fixed investment.  Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The FOMC is ignoring rising inflation data.
  • The FOMC needs to chop the “dead wood” out of its statement.  Brief communication is clear communication.  If a sentence doesn’t change often, remove it.
  • In the past I have said, “When [holding down longer-term rates on the highest-quality debt] doesn’t work, what will they do?  I have to imagine that they are wondering whether QE works at all, given the recent rise and fall in long rates.  The Fed is playing with forces bigger than themselves, and it isn’t dawning on them yet.
  • The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent increases in employment, or a US Dollar crisis.  Labor employment is the key metric.
  • GDP growth is not improving much if at all, and much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.

A Brief Note on Dividend-Paying Common Stocks

Monday, June 16th, 2014

The equity strategy that I have run for the last 13+years always has a slightly higher yield than the S&P 500.  But I never look for dividends.  It’s not a factor in my process.  That said, looking for businesses that produce free cash flow, and voila, the dividends appear.

At present, with interest rates so low, many people look at dividend paying common stocks as a means of obtaining income.  They also add REITs, MLPs, BDCs, and an assortment of other things that trade like stocks and have yield.  I don’t think this is a safe way to get yield, at least not now.  Here’s why:

1) Think of the 1970s, when I was a teenager.  Not only were interest rates higher, and inflation eating away at purchasing power, but when companies got into trouble, they would cut their dividends, and often severely.  During that era, you had to make sure that the company was actually earning the dividend, or were they borrowing to pay it.

2) There have been many flameouts in REITs, especially mortgage REITs.  I remember buying broken mortgage REITs in the mid-90s at less than half of their net worth after they had bought exotic CMO pieces, trying to create funds where the value rose as interest rates moved higher.  They got crushed in the early-90s by Greenspan’s hyper-easy monetary policy.  In 1994, as rates were rising, they rallied significantly.

Mortgage REITs also got crushed in 2008-9.  But Equity REITs have their times of trouble as well — they tend to be bull market babies.  When commercial real estate is doing well, they do extra well.  When it goes badly, extra badly for the REITs because of all the leverage.

3) I mentioned 1994.  In 1994, as rates rose, dividend paying stocks underperformed.  The value manager that Provident Mutual used at that time was an absolute yield manager.  In other words, that manager only bought stocks that had a yield higher than a fixed threshold.  At that point, the threshold was 4% or so.  From 1982 to 1993, as interest rates fell, this manager was golden, but it was an artifact of the era.  In 1994, the performance was abysmal.  The manager was replaced the next year.

High yielding stocks paying out a large portion of their earnings as dividends tend to have their dividends grow slowly, because there is little left over to reinvest into new business.  It is akin to owning a bond disguised as a stock.  Lower-yielding stocks often grow their dividends more rapidly, as they reinvest more free cash into new business.  With Equity REITs, the latter strategy has generally been more successful.  Better to buy the lower yielding REITs that grow their dividends faster.

4) The REITs, MLPs, and BDCs that pay out a a high proportion of their taxable income are weak vehicles because they are forced to pay out so much.  During crises, that really bites them.

(This wasn’t as short as I thought it would be.  Oh well.)

Conclusion

If interest rates rise, and I do mean if, because the economy is weak, be ready to see these modern income vehicles take a hit.  If we have a severe recession, be aware that dividends do get cut.  Do not rely on stocks for income.  Bonds are designed for income and return of principal.  Stocks are designed for gains or losses depending upon the underlying business performance.  They aren’t income vehicles, but performance vehicles.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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